By Ryan C. Wood
Yes. There are a number of situations that could create this dilemma for a bankruptcy filer. The issue is about a state court claim or cause of action, say breach of contract, which is prosecuted in state court and then the judgment debtor files for bankruptcy protection. In many collection lawsuits the allegation of fraud is not made since it is far more difficult to prove. Only the breach of contract claim is listed and sued for in state court. If the defendant files for bankruptcy protection can the plaintiff, or judgment creditor if a judgment was obtained, then file an adversary proceeding alleging the claim or judgment should not be discharged because of a potential fraud cause of action that the state law statute of limitations to sue has expired? Yes. See: Banks v. Gill Distribution Centers, Inc. (In re Banks), 263 F.3d 862, 868 (9th Cir. 2001); Lee-Benner v. Gergely (In re Gergely), 110 F.3d 1448 (9th Cir.1997); Resolution Trust Corp. v. McKendry (In re McKendry), 40 F.3d 331 (10th Cir.1994).
In Banks the argument was whether the bankruptcy court is compelled to ignore a state statute of limitations entirely in determining the dischargeability of a debt? The bankruptcy court held a claim upon which the state statute of limitations had run pre-petition has been “established” pre-petition “if the creditor has taken a timely affirmative act which is necessary to the creditor’s ability to collect the debt in a manner provided for by law.” In re Banks, 225 B.R. at 745. If there is a valid pre-petition judgment, even if the judgment is not based on fraud, then the creditor is not seeking a new money judgment, but the creditor is litigating the issue of dischargeability and whether the adversary proceeding is brought timely is governed by bankruptcy rules. The Supreme Court of the United States in Brown v. Felsen, 442 U.S. 127, 99 S.Ct. 2205, 60 L.Ed2d 767 (1979) held that res judicata does not prevent a creditor from offering evidence of a debtor’s fraudulent conduct in a dischargeability proceeding where the creditor had not pled fraud in the original state court lawsuit. The creditor is attempting to meet a new defense of bankruptcy which the debtor interposed by filing for bankruptcy protection and seeking a discharge of debts.
In the Banks case creditor Gill did not assert a fraud claim in his state court lawsuit and the statute of limitations had run on a fraud claim, but creditor Gill is not prevented from raising fraud in a bankruptcy dischargeability adversary proceeding. A bankruptcy court can make the determination that the claim was a fraud based claim regardless of whether that argument was raised in state court. It does matter whether the creditor obtained a judgment pre-petition or the lawsuit is still pending in state court. A creditor does not have to obtain a judgment pre-petition to establish a claim once a bankruptcy case is filed. As a bankruptcy attorney we include a paragraph in our retention agreement that adversary proceedings are possible in any bankruptcy case that is filed. Creditors have to have a way to object to the discharge of the debt owed to them under the grounds provided by the Bankruptcy Code. That is an adversary lawsuit arguing the debt owed should not be discharged. The distinction being discussed here is what can be argued in the adversary proceeding.
What This Means To Bankruptcy Filers?
The take away from all of this is just because there has been no mention of fraud in a state court lawsuit does not mean a creditor cannot raise it later if the defendant or judgment debtor later files for bankruptcy protection and seeks to discharge their debts. The state law statute of limitations for the cause of action expiring also is not a bar to the creditor raising the issue of fraud in the later filed bankruptcy case either. Bankruptcy attorneys need to be aware of these two issues when a lawsuit could be filed, a lawsuit is pending or a judgment was obtained pre-petition. Many creditors will look into alleging some sort of fraud once the bankruptcy case is filed and argue the debt should not be discharged pursuant to Section 523(a)(2) of the Bankruptcy Code. That is the entire point of all of this and what these parties are arguing about. Does a creditor get another bite at the apple when the person that owes the money files for bankruptcy protection and seeks a discharge under bankruptcy law? Again, the answer is yes. Just because allegations of breach of contract or a judgment is obtained pre-petition for breach of contract does not mean the judgment is not dischargeable.
There are a number of issues regarding the dischargeability of a pre-petition claim. Depending upon whether the judgment has been perfected pre-petition and when is how the judgment will be treated in the bankruptcy proceeding. Most judgments are treated as a general unsecured debt still and dischargeable since the judgment is not secured by any collateral. The judgment has to be perfected and be secured by physical collateral to be treated as a secured debt in which the judgment lien survives the bankruptcy discharge. That is the key. The pre-petition attachment or securing of the judgment will survive the bankruptcy discharge even though the underlying personal liability for the debt is discharged. The entire point of the creditor now making the fraud argument is to not have the underlying debt discharged. When a creditor just has a judgment then the natural response is to look into other ways to make sure the judgment does not go away. That is when the creditor raises fraud claims once the bankruptcy case is filed in an adversary proceeding pursuant to Section 523(a)(2).